Rosenberg’s Take On The Election Results & Other Matters

Posted by David Rosenberg - Gluskin Sheff

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From today’s Breakfast with Dave: Market Musings & Data Deciphering

There are just some articles that are worth reading and re-reading. What I’m talking about are some of the columns that found their way into yesterday’s WSJ editorial pages. Agree or disagree, but they were brilliant, particularly Why Obama is No Roosevelt by the venerable Dorothy Rabinowitz and Democrats Can’t Blame the Economy by Fred Barnes on page A21. The analyses are simply phenomenal. Obama’s Next Worry: A Restive Left Flank by John Fund on page 19 was not that far behind. If you missed these — I read them on the flight back from Boulder — I highly recommend that you get your hands on them.

It is hard to disentangle the effects of investors’ high hopes that the Fed’s looming QE2 program will work and how a GOP victory will shape the political outlook, in terms of what has really helped the stock market turn in back-to-back months of really solid gains.

My sense is that the expectations of a shifting political backdrop have been more dominant. Now I fully subscribe to the view that gridlock is not a good thing when the economy is suffering from a variety of intense structural problems and yet strong and effective leadership is lacking. But the market seems to be viewing the mid-term election as a barometer of Barrack Obama’s potential to be a two-term president. According to an Associated Press poll, 51% of Americans believe he does not deserve another chance in 2012 and amazingly, 47% of Democrats want him challenged in the primary, which would be a death-knell since in the past 50 years, every president that faced a fight for the party nomination lost the election (Ford, Carter and Bush senior). There are all sorts of stuff like this in the John Fund piece.

That aside, Mr. Market likes the fact that the Republicans are now going to assume control over the legislative agenda — oversight and expropriations to be precise. The push for “card check” unionization will be set back, and union political contributions are likely to be curtailed. Mr. Market probably does not mind at all that labour’s influence over the policy agenda is about to be rolled back. The beleaguered banks could emerge here as a big winner if the GOP translates into fewer teeth for the SEC in its quest to enforce the recently-legislated Dodd-Frank financial regulation bill. Foreclosure moratoria, supported by the likes of Harry Reid, are far less likely to re-emerge. Little wonder, then, that the NYT reported that 71% of financial sector donations are now being diverted to the Republican campaign compared to 44% a year ago.

There is a growing hope that the Tea Party has tapped a raw nerve and will serve as a lightning rod for change. And change is needed in a really big way when one considers the financial strains that mandatory entitlements, such as Social Security, will pose as the demographics, in terms of an ever-higher dependency ratio, ascends further. These mounting “locked in” fiscal costs have to be addressed as do the $3.5 trillion of actuarially unfunded state/local government pension plans. Social contracts will have to be re-written — perhaps with implications for contracts with bondholders.

But hope is never a good strategy. Results are what matter. It took two full years for the Reagan rally to really take hold. An economy growing at a 7% clip in the aftermath of the 1980-82 malaise and an unemployment rate that came crashing down more 300 basis points from the highs certainly helped. So, while there is hope that the stage is being set for meaningful political change in 2012 (where the Republicans stand a very good chance of reclaiming BOTH the House and the Senate) the near-term outlook is muddled. Investors should not lose sight of the fact that the recovery is so listless that we are only one negative shock away from tilting the economy back into contraction mode.

Let’s not forget, we have a weakened U.S. president and a lame-duck Congress on our hands at a time when some serious decisions have to be made that could make-it-or-break-it in terms of a ‘double dip’. Unless the Bush tax cuts are extended, 150 million people will be facing a higher tax bill starting January 1. If exemptions are not passed, then 29 million Americans will fall into the Alternative Minimum Tax (AMT) trap (seven times as many as this year). If left untouched, the estate tax rate jumps to 55%. And, another two million folks are about to roll off the extended jobless benefits, with an income drain estimated at $30 billion dollars, if not more — and at a time when rising food and energy costs are bound to divert consumer spending away from discretionary and cyclical consumer spending.

As for the Federal Reserve — on this score, it is not at all obvious that QE2 is going to have that much of an economic impact; the economy hardly lacks ultra-low interest rates nor does it suffer from a lack of liquidity. As an aside, according to various macro models, even a $500 billion package would exert just a 0.25% positive impact on GDP growth (see more on page C1 of the WSJ). The markets are operating efficiently. This was not the case with QE1 when mortgage spreads and corporate bond spreads were in the stratosphere and the capital markets were closed for business.

Is another 50bps cut to the general level of interest rates from their current record-low levels, at the margin, which is what a $500 billion QE2 plan would entail, really convince debt-strapped consumers who are focused on balance sheet repair to go out and borrow and spend more? Or will it entice capacity-idled companies that are already sitting on a trillion dollars in cash to go on a spending and hiring spree (today’s WSJ cites a survey showing that corporate R&D spending has declined for the first time in over a decade)? Even before today’s FOMC meeting, companies like Northrop Grumman was floating a $500 million 5-year note at a yield of 1.85%! Are the banks, who just sat on excess reserves the Fed plowed into the financial system in early 2009, going to unclog the credit channels when nearly one-in-three American households have a sub-620 FICO score and 25% of outstanding mortgages are “upside down”? Hardly likely.

Maybe the Fed will successfully bring risk asset values above their intrinsic levels to induce a more positive “wealth effect” on spending, but that has proven to have been a failed strategy over the last 15 years, which only ended in tears. Why go there again unless this is for short-term expediency? Maybe Bernanke et al will manage to depreciate the U.S. dollar even more but this risks a trade backlash from other countries, not to mention enticing speculative capital flows to emerging markets where inflation pressures are starting to intensify (and met with tightening measures out of China, India and Australia). The Fed simply does not have the appropriate tools to deal with the myriad of structural hurdles facing the economy, ranging from housing, to debt, to commercial real estate, to state and local government cutbacks and fiscal disarray, to excessive regulation, and the list goes on.

Moreover, if we are talking about the Fed having a really meaningful impact, like enacting a policy that can actually close the output gap completely and totally limit deflationary risks, the numbers we have seen are in the range $4 to $5 trillion worth of asset buying from the central bank. Imagine a Fed balance sheet so big it would be half the size of the overall economy. Yikes! Just the thought of it makes me want to go out and buy more gold and silver mining companies.

What really caught our eye was what Robert Gordon, the Northwestern professor who sits on the NBER (National Bureau of Economic Research) business cycle dating committee, had to say to the NYT on this matter:

  • There is a substantial chance that the U.S. economy is headed into a lost decade, similar to what Japan has experienced in the past 15 years, possibly with zero inflation instead of actual deflation. But the consequences for the U.S. population will be much more severe than in Japan because of our higher unemployment rate, our lack of a social safety net, our system that ties medical insurance to employment instead of making it a right of citizenship, our greater inequality and our higher level of poverty.”

Ouch. Talk about being blown away.

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